Impediments to Innovation

September 10th, 2010 Mike

There’s a lot of talk and discussion about what we can do in Canada to stimulate more innovation and commercialization of research.

While it’s great to have incentives such as the SRED program and tax credits (like the BC investment tax credits) to provide incentives to entrepreneurs there are also some impediments which discourage new venture creation.

At the top of my list are: Stock Options taxation and Securities Regulations Exemptions for raising Capital.

Regarding Stock Options – they key point here is that if a company gives stock options to a key employee (e.g. to attract someone to join the firm), and that employee exercises the options (which is a good idea in order to take advantage of both capital gains and the life time capital gains exemption) then that person has a tax liability which is assessed on the “benefit”, i.e. the gain on paper – the current share value less the exercise price.

This liability does not go away – even if the company fails. Not many people know this. If that’s not an impediment, I don’t know what is. See my more detailed discussion on this in another posting.

Regarding Securities Regulations Exemptions – when private companies raise capital, they must always relay on a so-called “exemption”, i.e. and exemption from having to file a full-blown prospectus allowing them to issue shares to the general public. Companies can easily sell shares to people known by the founders – family members, friends, and business associates (there’s an exemption for this). But, they cannot easily sell shares to other investors unless those investors are “accredited” (there’s a definition for this, but it roughly means that an investor has to be a millionaire or have a high income). Only 2% of the population are accredited and, of course, most of that 2% does not invest in speculative high tech deals. The only other exemption is to prepare an “Offering Memorandum” which is almost like a prospectus, but somewhat less rigorous. It does cost time and money to prepare one and it does add some on-going overhead expenses (e.g. full-blown accounting audits are required). For major financings, it may be worth the trouble, but for a few hundred thousand dollars in start-up funding, it’s a genuine hassle not to mention the delays and considerable expense.

There’s currently no easy solution to this. To the regulators, I would suggest that non-accredited investors simply be required to sign an affidavit that they have done their due diligence and are willing to lose all their money (like they do after being given an Offering Memorandum).

In the meantime, another way is through small “angel” seed funds in which non-accredited investors could invest. And, I just happen to be involved with a new experimental publicly-listed investment company whose shares anyone can buy in the public market. This company, GreenAngel Energy Corp, raises capital and invests it in the initial seed rounds raised by clean energy technology ventures.

I hope that this model will be used to create modest capital pools for other fields of interest. We need to tap that huge financial resource of joe-average-investor and deploy that capital towards stimulating more innovation!

Footnote:

Here’s a suggestion: Let companies raise modest amounts from investors, say a limit of $25,000 per investor (with no offering memorandum – just a risk acknowledgment) and at the same time let them write off the investment. For the majority of investments, this usually happens anyway. So let them take the write-off now in order to get a tax break and stimulate more investing. If the investment pays off, they pay capital gains on the entire proceeds.